Joke of the day and why laddering of bonds is not totally risk free

Sorry for not writing something during the last few days. I was busy trying to salvage some of the losses created by this credit meltdown. Even mighty Hang Seng bank was indirectly affected by the U.S. credit meltdown (hint: It also owns bonds of Washington Mutual Bank).

So, let me start this message by re-broadcasting something that made me smile today:

Two cannibals decided to cook a comedian. During dinner, one cannibal said to the other: Something tastes funny.

…And other tidbits

Now back to some thoughts running through my mind. Oh, yes, the laddering of bonds strategy. As most financial advisers will advise you, bonds are considered safer than stocks when it comes to risk management. One strategy followed by a lot of investors is to ladder a series of bonds, according to their maturity date. In this way, the investor will have a regular stream of interest and cash (when the bonds mature).

What this laddering strategy does not take into account is that it gives an investor a false sense of security. When the bonds are purchased, they may have a high grade rating from the rating agencies. We are talking corporate bonds and municipal bonds (U.S. Treasury bonds are not discussed because, frankly, if the U.S. government goes under, we are all poor). However, over time, the economy changes and so does the fate of the corporations, and I quote from Bloomberg (for full article see here):

Bond investors are reticent to buy after being burned by what were once some of the highest-rated institutions. New York- based investment bank Lehman, rated A2 by Moody’s Investors Service and A by Standard & Poor’s until its collapse, filed for the biggest bankruptcy ever on Sept. 15.
The next day, New York-based American International Group Inc., the biggest U.S. insurer and rated A2 by Moody’s and A- by S&P, was forced to obtain an $85 billion loan from the government in exchange for an 80 percent stake. Lehman’s bonds have lost 86 percent on average this month, and AIG is down 37 percent, Merrill index data show.
Washington Mutual, the 119-year-old Seattle-based thrift, became the biggest U.S. bank to fail on Sept. 25. Its bonds have tumbled as much as 99.8 percent this month. Washington Mutual was rated investment-grade by Moody’s until Sept. 11 and by S&P until Sept. 15.

So what shall an investor who ladder bonds and hold them to maturity do? Careful research and willing to pull the trigger and sell if you perceive a bankruptcy is coming. I must admit that I wasn’t so detailed in my research when it came to determining the status of corporate bonds. Also, never trust what the corporate officials say. Do your own research.

Another advice, as a bondholder who got burned by Washington Mutual, is to avoid for the time being any corporate bonds of financial institutions that are subject to government control. In this instance, Washington Mutual was under the jurisdiction of the FDIC. When the FDIC took control of Washington Mutual, it did the extraordinary action of removing most of the assets of Washington Mutual and give them to JP Morgan Chase. As far as the FDIC is concerned, its primary function is to safeguard the deposits of the bank’s customers. However, on prior occasions when the FDIC took such drastic actions, it also required that the buyer of a failing bank took the creditors. But that did not happen in this case. Maybe the FDIC decided that given the number of failures, it better save some of its own amunition. That meant that the bondholders of Washington Mutual were presented with a different universe when Washington Mutual filed for bankruptcy (see this article) and the expectation of recovery is quite low. Now my readers, do you wonder why the credit crisis has worsened? On top of the lack of confidence on what is on the account balance of financial institutions, there is now the added danger that the FDIC may remove all assets of a failing institution and forgetting the creditors. As the saying goes, “fool me once shame on you, fool me twice shame on me.”

 

See also this blog.

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